Modalities and firms profile for SME funding - report 8

 5.1 Modalities
241. In the case of crowdfunding, individuals provide the firm with financial help. Crowdfunding
generally takes place through social networks, internet especially, with the entrepreneur detailing the
business activities and objectives, in some cases in the form of a business plan, and requesting funding
under specific terms and conditions. This represents the main innovation of crowdfunding with respect to
other forms of finance, as the entrepreneur does not need an intermediary, such as a banking institution, to
seek funding and can source directly the savings of a large audience.
242. Crowdfunding is not only a mean to raise funds, but can also represent an important mechanism
to share information with a large public, increase awareness about projects and products, seek feedback to
improve them, and get recognition which may help in future commercialisation (Metzler, 2011).
243. The type of contributions by the investor – and related rewards - may vary, depending on the
internet platforms, the type of firms and the projects. 

Indeed, as new platforms are created across countries,
in a context of low regulation, new features and business models are continuously emerging. The types of
funding may range from donations to equity, thus giving rise to processes with different degrees of
complexity and different contractual relationships between the firm and the individual investor.
244. In broad terms, crowdfunding can take the form of (Hemer, 2011; Mitra, 2012):
1. Donations, whereby contributors donate funds, mostly for charities and non-profit organisations,
although for-profit organisations can also receive donations through this channel;
2. Reward or Sponsorship, whereby contributors receive a pre-defined reward, such as a small
token of appreciation or some type of service, like a public acknowledgment for their
contribution and marketing;
3. Pre-selling or pre-ordering, whereby investors provide funding to help produce some product or
service and in return receive an early version of the product, or the product at a reduced price;
4. Lending, whereby investors receive the interest and the principal at the end of the lending period.
There exist also crowd-lending forms based on the revenue-sharing principle, that is, where
creditors are not paid interests at the end of the defined lending period, but rather an amount
which includes an agreed share of the earnings, in case of good performance of the debtor.
5. Equity, whereby a privately-held company offers securities to the general public, through the
medium of an online platform. Investors receive a share in the business and may acquire voting

Donations, rewards and pre-selling (i.e. the so-called “non-financial” crowdfunding) represent
the most widespread forms of crowdfunding and constitute an important share of the funding raised by
private companies through this channel, providing also non-financial benefits to companies and investors.
While these forms currently lead the industry, lending and equity based crowdfunding are expected to play
an increasing role in the future.
246. Lending-based crowdfunding, or peer-to-peer lending (P2P), has started as a form of loan
transactions in which individual consumers borrow from and lend money to one another, by means of
unsecured personal loans, without the mediation of a financial institution. This community lending implies
direct contact between the parties and, often, exchange of information that, through the internet platform, is
visible to other current and potential borrowers, and may help to broaden the creditor base. In fact, P2P
lending communities operate on the principle of “full financing,” i.e., the loan request gets funded only if it receives enough bids to cover the entire amount requested by the borrower within an established pledging
period, which may range from a few weeks to several months (Herzeinstein et al., 2008)

However, over time, crowd-lending has become increasingly mediated by online intermediaries.
In the case of lending platforms, typically the lenders purchase notes issued by the sites, which use those
funds to lend through Paypal or WebBank to borrowers (Mistra, 2012). Thus, the online platform acts as an
intermediary, for instance, collecting loan pledges from the crowd for private projects, releasing them at
the moment a target is reached, according to a threshold principle, collecting repayment instalments from
the debtor, and forwarding them to each crowd-lender25. In some business models, the pledged amounts are
transferred to an escrow account26, which is managed by the platform or a partner bank. Once the threshold
pledge is reached, payments are transferred from the escrow account to the project’s account (Hemer,
248. Peer-to-peer loans are usually unsecured loans, i.e. no collateral is required on borrowers,
although, in some cases companies may offer secured loans.

 Nevertheless, transaction fees and interest on
loans are charged by the online intermediary, which depend on the borrowers’ credit risk, as assessed by
accessing credit information from third parties or on the basis of information submitted by the borrowers
themselves. The online platforms typically develop credit models for loan approvals and pricing, and
perform credit checks of borrowers. Indeed, P2P platforms make profits from commissions instead of the
spread between deposit and loan. The longer repayment period that a loan lasts, the higher fees the
borrower has to pay (Lin, 2009; Chen and Han, 2012).
249. In the case of equity or investment crowdfunding, a firm offers a certain proportion of its equity
for a set amount of capital it is aiming to raise. 

Crowdfunded businesses do not have to adhere to the
strict accounting standards required of public companies and, at the same time, unlike other risk capital
providers, crowdfunding investors may have no experience in making such investments. As Collins and
Pierrakis (2012) underline, as the model taps into the sub–section of the public with an interest in
entrepreneurship, in many cases investment will also be motivated by non–financial aims, such as
becoming part of an entrepreneurial venture or supporting a particular individual or business.
250. The business model of equity platforms typically implies that entrepreneurs or project initiators
define with the partner platform a funding threshold and a time period for reaching the target, which is
divided into equal shares. These are offered as equity shares through the platform and, in a similar way as
the threshold model for crowd-lending, once the threshold is reached the investment takes place (Helmer,

 251. A key step in this process is the valuation of the business, in order to establish the amount of
equity to be offered in exchange for the target capital to be raised. In most cases, it is the entrepreneur
him/herself that performs this valuation, although the platform may allow for some upward flexibility in
the amount of equity that is offered, as the fundraising progresses and if the observed investment rate does
not allow reaching the threshold within the agreed timeline. Some platforms operate a market–driven
approach to setting valuation, whereby the entrepreneurs set out the amount of equity and number of shares
they are offering, and, through a bidding process, investors who are willing to pay the most for the shares
get in on the deal. Some platforms also provide to entrepreneurs training on how to value a business,
engaging ex–investment bankers, fund managers and venture capitalists (Collins and Pierrakis, 2012).

5.2 Profile of firms
254. Since the late 1990s, the diffusion of crowdfunding practices has been especially related to nonprofit organisations and the entertainment industry, where non-monetary benefits or an enhanced
community experience represent important motivations for donors and investors. To date, projects with a
creative or social focus, where non–financial rewards are offered in return for donations, have been the
most successful at raising finance from the crowd (Collins and Pierrakis, 2012).
255. Nevertheless, over time, crowdfunding has become an alternative source of funding across many
other sectors and it is increasingly used to support a wide range of for-profit activities and businesses. New
product-development is an activity for which crowdfunding can provide specific advantages, as the
financial dimension is importantly complemented by direct contact and feedback from current and
potential customers.
256. In this regard, Belleflamme et al. (2011) highlight the importance of community-based
experience for crowdfunding to be a viable alternative to traditional funding. In relation to reward or prepurchase funding, however, they also show that crowdfunding is the most profitable option only for lower
levels of finance, when the entrepreneur can use the mechanism to apply price discrimination, where
consumers with the highest expected valuation are willing to pre-order, i.e. to crowdfund, at a higher price
than other customers. When the amount required becomes larger, the entrepreneur is forced to distort more
the prices to attract a larger base of crowdfunders, which reduces the gains from price discrimination.
257. The crowd-lending, or P2P lending, option can be attractive for small businesses that lack
collateral or credit history to access traditional bank lending, as the loans offered are typically unsecured.
P2P lending, however, is not only attractive to highly risky or “unbankable” borrowers. Indeed, the main
platforms for crowd-lending have been increasingly targeting high quality credit risk, often providing loans
to refinance credit-card debt, and incentivising lenders to conduct thorough credit checks of applicants
before accepting them, which has limited default rates. On their side, borrowers can receive lower rates
than those offered by banks, since overhead costs and regulatory burdens are lower, as well as benefit from
the interaction with customers that these platforms typically provide.
258. Equity crowdfunding can provide for a complement or substitute of seed financing for
entrepreneurial ventures and start-ups that have difficulties in raising capital from traditional sources, like
bank loans, venture capital, business angels and also public programmes, because they are too innovative
to be understood, too complex, too risky or simply because the business plans are poorly presented
(Helmer, 2011).

  259. Crowdfunding has the potential to deliver equity finance to ventures that have greater levels of
risk attached relative to the potential financial gains they can deliver. The non-monetary motivations of
crowdfunding investors, such as being part of an entrepreneurial venture or receiving non-tangible rewards,
can explain, at least in part, why they may be willing to accept more risk or less return than traditional risk
capital investors. At the same time, the small amounts committed to many ventures may allow them to
effectively spread their risk, in a cost effective way (Collins and Pierrakis, 2012).
260. By design and because of regulatory limitations, crowdfunding is suited to start-ups and
businesses that request relatively small amounts of funding. However, this depends on the extent to which
larger investors participate in the process, as there have been some cases where the potential of the model
to raise larger amounts has also been shown (Collins and Pierrakis, 2012). Indeed, large companies have
been increasingly investing through crowdfunding platforms, which can offer access to promising start-up
ventures. In some cases, crowdfunding challenges have been set up by large firms, offering the most
competitive start-ups to match the funds they raised from smaller investors28.
261. According to Collins and Pierrakis (2012), some business models and sectors may be more suited
to crowdfunding than others. In particular, consumer–facing businesses may find the instrument more
suitable to their needs, as traction with the potential customer base, as shown by the ability to raise fund
through the platform, is an integral part of proving to investors the viability of their proposition. Signalling
is one of the most important functions of crowdfunding, and a large number of supporters suggests that
there exists already a core market for the firm’s product or service, which can be easily mobilised to
broaden the market through personal contacts and social networks (Helmer, 2011). Also, crowdfunding can
benefit new ventures built on some R&D output, as the interaction with customers may allow the
entrepreneur to validate the untested product or service (OECD, 2014c).
262. On the other hand, the crowdfunding channel may be less suited for business models that are
based on complex intangibles or innovations in very high–tech and cutting edge areas, which require
specific knowledge on the side of investors (Collins and Pierrakis, 2012). In this regard, however, Helmer
(2011) notes that the crowdfunding mechanism may attract a certain group of investors that seek ventures
with some degree of innovation in specific fields, such as IT experts, engineers, scientists or people with
visions of future applications. Besides funding, they may also bring in knowledge, experiences and
networks to shape business strategies and craft products (OECD, 2014c). 

263. Furthermore, crowdfunding may not be appropriate to fund firms for which business information
and financial details are too sensitive to be shared with a large number of potential investors, as it is either
impossible or legally very difficult to arrange non-disclosure agreements with all of them. In addition,
crowdfunding may not be suited for businesses that are particularly capital–intensive in early stages or
those that require the types of post–investment support that can only be provided by institutional investors
(Collins and Pierrakis, 2012; Helmer, 2011).
5.3 Enabling factors
264. Crowdfunding activities require a reliable internet connection, access to the banking sector (in the
form of bank accounts for entrepreneurs and investors) and/or online payment systems for the funds to be
transferred. In this regard, an efficient banking system can ease the development of crowdfunding
platforms, by providing the infrastructure for payments, as well as information about the creditworthiness
of the entrepreneurs. In the case of crowdlending, for instance, the platforms may use credit history to 

252. An emergent business form of equity crowdfunding platform is the “holding model”, as defined

by Helmer (2011), whereby the platform creates a subsidiary company, which operates as an individual

holding for each of the crowdfunded ventures. In this case, it is the holding company that owns the

company shares and sells them to the crowd, acting as a single investor in the firm, alongside other

potential investors from the conventional capital market27.

253. As experience and professionalism increase, crowdfunding platforms are evolving into more

sophisticated intermediaries, which may offer other services beyond the facilitation of funding, such as due

diligence, consulting, search for co-investors or management of a co-investment fund (Helmer, 2011). 

decide on whether to accept a project for financing through their site and on the interest rate to charge
(OECD, 2014c). (
265. The development of the Web 2.0 has been critical to the diffusion and evolution of crowdfunding
platforms and practices. Through the Web 2.0, access and use by many different individuals is made easier,
knowledge and resources from several sources can be combined, and openness allows users to contribute
freely to different projects. This can especially broaden the capabilities of small businesses, allowing user
content to inflow and create value for the firm (Lee at al., 2008). With the evolution of the technology, as
more applications are possible, crowdfunding platforms have been experimenting with new business
models and financing forms.
266. The diffusion of crowdfunding has also been favoured by an emerging internet-based community
culture, whereby individuals are motivated to share ideas and contribute to some collective endeavour, as
in the case of “open source”. However, as Belleflamme et al. (2011) note, crowdfunding differs
significantly from the open source model, when the resources belong to the community, which can exploit
them on an individual basis. In the case of crowdfunding, the key resource, capital, ultimately belongs to
the firm, which will be the only one able to use it.
267. While the pace of technological developments has enabled a rapid diffusion of crowdfunding, the
regulatory environment has limited its diffusion, especially for securities-based crowdfunding, which is
still not legal in some countries. The nature of crowdfunding does not make it possible to regulate the offer
as “private placements to accredited investors”. Rather, it is considered as public offering of securities,
which is highly regulated in most countries and often requires the publication of a sales prospectus that
must be accepted by a supervisory authority. The procedures involved are typically complicated, timeconsuming and costly, and can be prohibitive for the entrepreneurs or small businesses approaching
crowdfunding (Helmer, 2011; Mitra, 2012). To overcome such difficulties, some platforms set up
“investment clubs”, which potential funders can join. In this case, the regulatory provisions are less strict,
since the members of the club are regarded as qualified investors who need less protection than the
“general public” (Helmer, 2011).
268. Another regulatory obstacle to crowdfunding is the legal limit to the number of private investors
a company can have. By its nature, crowdfunding aims to collect contributions from a large base of
investors. Also for this reason, most crowdfunding initiatives do not offer shares, but other types of
rewards, such as a product or membership (Belleflamme et al., 2011).
269. To date, the nature of the business has led to great caution by regulators. At the same time, the
lack of a clear regulatory framework vis-a-vis a new form of debt or equity issuance has contributed to
caution by the investment community, in the light of concerns about how much protection they have
against fraud, the public disclosure of sensitive information, and the management of a large number of
shareholders (Collins and Pierrakis, 2012). Especially, crowdfunding practices raise questions with respect
to corporate governance and investor protection, as crowdfunders are most likely to be offered very little
protection. Relatively to traditional bank finance, the industry is more vulnerable to the risks of cyberattacks, identity and payment data theft, as well as money laundering (OECD, 2014c). Also, as the
individual investment is generally small and the investors typically lack experience, there is a lack of
incentive or capacity to intervene in case of mismanagement or abuse (Belleflamme et. al, 2011).
270. It is however to be noted that the regulatory environment is changing rapidly. In recent years,
important regulatory changes have been proposed or implemented in some OECD economies, to enable
greater access and use of crowdfunding by entrepreneurs and investors. The exemptions to general rules to
secure investors or the implementation of ad hoc regulation are expected to facilitate the growth of the
industry (see policy section).

271. Securing an exit for crowdinvestors is also important for the spread of equity crowdfunding. The
evidence about successful exits is still limited, but some recent cases suggest that, even when the
crowdfunded business is sold to a large investor, it is likely that the shares of previous investors will be
diluted, following other crowdfunding campaigns or separate deals with angel investors29. 

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